A Risk-Based Rationale for Two-way Capital Flows: Why Do Capital Flights and Inward Foreign Direct Investments Co-exist?

This paper develops a positive theory of two-way capital flows -- the simultaneous outward flight of capital assets, and the inflow of foreign direct investment that acquires ownership of local production units. The basic model exploits insights from entrepreneurial decision making under uncertainty in a general equilibrium setting, and traces out the relationship between (i) entrepreneurial incentives to exploit higher expected profits from risky production activities at the firm level and (ii) the resulting competitive rewards to capital in general equilibrium. The model shows that contrary to expectation, relatively liquid capital assets tend to flow from capital-poor to capital-rich economies, while foreign direct investment aimed at acquiring ownership of production units follows the reversed pattern. We also examine the optimal investment policies for both host and origin countries, and show the rationale behind the inherent conflict of interests between developing and developed economies in the context of capital market liberalization.